SU7 - Financing

Question 1

Through which methods can a firm finance its fixed assets?

Answer 1

1. Equity or

2. Long-term debt

Question 2

What are the tax benefits of paying interest?

Answer 2

1. It is an expense item in the firm’s statement of financial performance
2. It reduces the earnings before tax (EBT) used in calculating the firm’s tax liability.
3. After tax cost of debt = interest rate x (1 - tax rate)
4. The dividends paid on ordinary shares come from the net income (EAT)

Question 3

The firm’s cost of capital is also referred to as what?

Answer 3

The required rate of return

Question 4

Explain the Cost of Capital.

Answer 4

• The cost of capital depends on the proportion that each form of financing contributes to the total financing of a firm and the required rate of return on each form of financing.
• The cost of capital is a weighted average cost.

Question 5

Explain Financial Leverage (Gearing)

Answer 5

1. It involves the use of debt financing in order to increase the EPS and the value of the firm.
2. The value of the firm can be increased by lowering the firm’s cost of capital.
3. Cost of capital can be lowered by increasing the debt-equity ratio.